Bonuses - what is the future of remuneration for financial services?

Stephen Brooks

AB Direct

17 February 2012

Part of the furore surrounding Stephen Hester’s bonus and those of railtrack’s directors, is a result of politicians of all colours asserting that bonuses should be awarded only for truly exceptional performance. This displays a very poor understanding of the benefits of variable and performance related pay.

The variable pay approach helps to manage performance and costs. Paying part of the pay through bonuses decided at the end of the year ensures that banks can pay the majority of employees who are good but not exceptional, more than weaker performing colleagues. It also provides the organisation with some flexibility in its labour costs.

The so called ‘bonus culture’ was developed in investment banking and broking to help manage pay and labour costs in volatile markets. Last year, PA Consulting Group’s survey on the FSA Remuneration Code revealed that bonus restrictions had led many banks to shift remuneration away from bonuses and into higher base pay, which almost certainly contributed to the level of recent City job losses.

But a poor appreciation of reward management is only part of the story. The principal reason is a feeling that some, particularly bankers, are taking huge rewards and not sharing in the sacrifices others are making.

This is not helped by lurid and misleading reports about executive pay. Recently Income Data Services (IDS) announced that FTSE 100 directors’ pay in 2011 had been hiked by 49 per cent. This figure is widely quoted by politicians and pundits. But two days later IDS sheepishly admitted that 49 per cent is ‘far from the whole truth’.

They explained that directors’ earnings are complex and consist of salary, annual bonus and share-based awards, ‘each tied to different performance conditions and linked to different pay-out cycles’.

It means that a few people making large gains on share options can disproportionately influence the average increase figures. IDS went on to admit that the median salary rise was 2.1 per cent (in line with average pay rises in the economy) and the median increase in total earnings was 16 per cent.

This episode illustrates how difficult it is for the public to assess whether executive rewards are fair and justified. There is little criticism of the high rewards that go to people like Richard Branson, James Dyson or Elton John because we can all see that they have earned their rewards through the exploitation of exceptional talent.

The complaints about bankers and executives come because we cannot see whether they too are world class or what contribution they make to the wealth of their businesses.

This has led to too much focus on the size of executive rewards and too little on structure and its impact on executive motivation. The trend in executive pay has been to try and align pay to shareholder interests by using instruments that are driven by share price (options, stock or long term incentive plans based on total shareholder return). This is a key component of the FSA Remuneration Code.

This is misguided because share prices are volatile, reflect many factors and are only loosely connected to performance over the three to five year horizon of the remuneration plan. One of the criticisms of Hester’s bonus was that the RBS share price had fallen, even though this was most likely due to the Euro debt crisis.

Rewards linked to the share prices are likely to oscillate between windfall gains and unjust penalties. This means they place a huge premium on short term financial engineering over sustainable business building.

Shareholders and remuneration committees need new thinking on what they want from executives and how they judge their performance. They should adopt more of a stewardship approach, where executives are judged on business building and whether the organisation they pass on is in better shape than the one they took over.

This means performance should be assessed against measures that executives really can influence. Earning Before Interst, Taxes, Depreciation and Amortisation (EBITDA) for example measures operating profits before the financial engineers get their hands on them. This is a simple and understandable measure of business building and hence is much favoured by private equity owners. Equally, long term incentives should accrue over the long term – three years is long term only if you are a hedge fund manager!

Banking bonuses are most likely to decline anyway as the profitability of banks is restrained by new capital requirements. But unless the public can see a stronger link between what executives put in and what they take out, it is likely that Stephen Hester will not be the only banker to face intense pressure over their pay.